Nobel prize in economics highlights debate over CEO pay

One of the winners proposed a model for setting CEO pay, but recent scandals prove that it is too high and something has gone badly wrong with the way it is set

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How should a company set the pay of its chief executive? 

Bengt Holmstrom, an economist at the Massachusetts Institute of Technology, has won the Nobel Prize for Economics along with Oliver Hart, who can be found at nearby Harvard, in part for his work on that very subject. 

Mr Holmstrom, who is a former director of Nokia among other things, in the 1970s demonstrated how a principle, for example, a company’s shareholders, should design an optimal contract for an agent, say, their chief executive. 

His “informativeness principle” is a model for how the CEO’s contract should link their pay to information relevant to their performance, after due regard has been paid to weighing risks against incentives. The work has been developed, debated and refined since that time.

The award of the Nobel Prize is particularly apposite today given the fierce debate being conducted about executive remuneration packages in the light of yet more scandal. 

In the US, where the two men work, that debate is currently centred upon on the eye popping awards handed to executives at Well Fargo, a retail bank in the midst of a scandal over the creation of bogus accounts. 

John Stumpf, its chief executive officer, is to forfeit $41m (£33m) in unvested share awards, will not receive a salary while the bank investigates the scandal, and won’t receive a bonus for 2016.

Carrie Tolstedt, who headed the community banking unit that employed numerous workers who illegally opened unwanted accounts, has lost unvested share equity awards worth about $19 million. She also won’t receive any severance pay, or any bonus for 2016 and won’t  be able to sell any stock during the probe. 

It sounds painful, but they’ve both made considerable fortunes through working at the bank and as the writs fly, and the bank’s shares slide, the shareholders who hired them have lost considerable fortunes. 

Needless to say, the creation of new accounts was heavily incentivised, while staff were pressurised to meet unattainable targets. Clearly the risk - that people in this environment would end up gaming the system - wasn’t effectively weighed when the incentives and the targets were set. 

More fool shareholders for approving the awards in the first place, you might think. Perhaps they ought to read up on Mr Holmstrom’s work. 

But the problem goes beyond the methods used to set pay and design packages. 

The CEO pay pot had already been stirred by corporate governance research firm MSCI, which examined the packages of some 800 CEOs at 429 large and midsize US companies during the 10 years to the end of 2014. It also looked at the total shareholder return of those companies - a measure of the share price performance and of the dividends paid. 

The firm found that had you invested $100 in the one fifth of those companies with the highest paid CEOs you’d have made $265. However, if you had put your money with the companies that paid the least you’d have made $367.

This challenges the prevailing assumption that shareholders do better when they make a hireling an owner alongside them and incentivise them by handing them chunky share awards tied to company performance. 

What all the toing and froing, including Mr Holmstrom’s prize winning model, misses is a rather important point: There are social consequences to executive rewards as well as corporate and investment consequences. 

Companies do not exist in vacuums. At a time of rising inequality, and insecurity, the pay packages handed to their CEOs are contributing to the anger and unrest that are the consequences. 

It isn’t exaggerating to say that they played a role in both the disastrous Brexit vote and the rise of Donald Trump, a plutocrat promising to tear up the system up in favour of the ordinary working Joe. Scarcely credible, I know, but people are buying it even after the ugly revelations about his sexual behaviour that emerged over the weekend.  

Both phenomena have their roots in populist outrage at an economic system that appears rigged.

As such, it isn’t only model for setting CEO pay, and how it is linked to performance, that is at fault. The problem is not with agents, and principles, and the finer points of contract theory that the prize winners cast light upon. 

It is as much with the quantum of awards that have surged at a rate that far outstrips the growth in average earnings, where there has been any growth at all, and the effect that has had against the backdrop of an increasingly insecure and unequal society. 

The winners of the Nobel Prize for Economics are to be congratulated. They are clever, talented people who have done valuable work. For that they will split SK8m (£745,000). 

It is a tidy sum but it just serves to illustrate the point I just made. The average FTSE 100 chief executive will make that sum in less than three months. Their US equivalents will make it after an even shorter interval. For far too many that sum would represent a mere rounding error when set against their overall package including, I’m sorry to say, the bosses of Wells Fargo. 

What we really need to discuss is not the methods or the models used to set executive pay, but how best to bring it down to a more acceptable level given the unrest it is contributing to.